The rich get richer because of leverage. They don’t trade hours for dollars but instead have their money work for them. What does that really mean?
The market is full of value inefficiencies. Understanding how companies evolve and managing risk can multiply your money (or lose it all).
When you first hear of investing, it gives misleading connotations. You either think of it as a lottery or expect to make money always magically. But trading is far more than buying and selling stocks.
With so many types of investment, anybody can find the right fit for their financial goals, personality, and risk tolerance. But how do you compare so many? Everybody talks of them all the time, but it can be abstract to define what these investments are or how to get started.
Don’t take this article as an investing guide, but as an introduction to the many security types. You’ll learn why they exist, how they make you money, and where to start.
- What is a Stock?
- What Are Bonds?
- What Are Mutual Funds?
- What are exchange-traded funds (ETFs)?
- What are Retirement Plans?
- What are Cryptocurrencies?
- What are Commodities?
- What are Options and Futures Contracts?
- What Have We Learned?
What is a Stock?
We buy part of a company and make money whenever their value increases.
In a strict sense, a stock is the group of company shares, which represent part ownership of a corporation. Your investments grow or shrink, depending on the current company revenue and original purchase date.
Despite popular preference, some companies will remain private. While they could get more capital, owning and controlling the corporation matters more to them. Unlike publicly traded companies, private ones don’t need to share reports nor business plans.
You can still buy private company shares, but it will require approval. These have no obligation in sharing insider knowledge with investors, and they don’t need to follow up with annual reports. Should you invest in a firm you know little about?
Are you sure they did not falsify any documents and are a ticking time bomb?
For sure, investing in a private company planning to go public can bring lots of profits. You could buy those shares from venture capital markets known as pre-IPOs (initial public offering). After it goes public, you can sell them like any other stock.
How to do it?
If you Google “where to buy stocks,” be ready to find dozens of sponsored stock exchanges. First, read some reviews to know which one to pick based on stock variety and fees.
After you open an account and verify it, you can link your bank account to transfer funds. You’re now ready to check the markets online and place orders.
As an active trader, you can also set price alerts, stop-loss orders, and news notifications.
What Are Bonds?
If price projections sound too risky for you, look instead for predictable returns. When buying bonds, you’re lending money to an organization, receiving interest until they pay it back.
- The face value shows the borrowing unit, also seen as the minimum purchase. If you want to lend 10K to a company issuing $1000 bonds, you buy ten of those.
- Maturity shows the time required before you can get back your amount.
- Coupon rates represent the interest you’d receive after some time, often every six or twelve months.
Although the bond price may change, recurrent interest remains the same for fixed face value:
A one-thousand bond will still be 1K after reaching its maturity. At a 5% coupon rate, You receive $50 regardless of the bond price.
How we perceive the rate compared to the current price is different. Say this $1K Bond has raised its price to $1.5K. If you compare the recurrent $50 with this new price, your rate has reduced to 3.3%. If its prices fall to $500, $50 stands for 10% of interest.
Of course, neither lenders nor corporations want to lose money. If a company predicts that bonds will not benefit them, they may allow you to recall all the sum before reaching maturity. Investors may want to retrieve their capital if they found a better bond offer and want to invest there instead.
Also known as callable bonds, you can request the amount at any time and get it back plus a little extra, which is the “call value.” Early redeeming a $1000 bond may get you $1020 while waiting more years lowers the call value. This number doesn’t concern much, since bondholders make their profits from coupon rates.
Unlike stocks, bonds limit their upside to a fixed rate. You don’t win as much, but you neither lose. Then why not go with the highest coupon rates?
What does high interest tell you about a company? It often means they are a riskier organization. They can default on your loan if they go bankrupt. There’s nothing wrong with higher rates as long as you know who you’re lending money. When getting bonds from the government, you take less risk than with corporations.
More maturity time and lower coupon rates are safer since they reduce the chance of default. However, when investing in non-callable bonds, you may end up with lots of funds trapped for decades. That means uncertainty because of inflation.
What are US Treasury Bonds?
Treasury bonds will bring security to all those investors looking to preserve their wealth. Unless the government stops collecting taxes (very unlikely), they will have the means to pay back your loans plus interest.
Given that most have 10-30 years of maturity, mostly long-term investors use Treasury (T-Bonds). Other risk-free securities include Treasury Bills, Treasury Notes, and TIPS (Treasury Inflation-Protected Securities).
Inflation-Linked Bonds Explained
Along with I-Bonds, TIPS are the primary securities protected from inflation. The face value of your bond will adapt to whatever is the currency value at that time. It guarantees you receive the same economic value, which can benefit in times of recessions.
The downside is, you miss the gains in case of deflation. In a volatile economy, inflation-protected bonds may be a limitation. The government may pay you back at an inconvenient time. As soon as you retrieve the initial amount, you are exposed to the inflation problem (unless you invest back).
They’d better give you high coupon rates because your adaptable bond may cost extra annual tax. Unlike fixed-income assets, the government considers annual income any variation from the original bond price (also known as phantom revenue).
Every year, you’d pay taxes for money you won’t receive until maturity. If you can call back the bond, the downside isn’t that problematic.
How to do it?
You can buy government and corporate bonds when registered in Vanguard, Etrade, Fidelity, Charles, Schwab, or other well-known platforms.
Select a dozen of them and compare features. Each bond includes a rating scale to help assess the risk (from AAA to BBB-), although they’re not necessarily accurate. Use them to complement your research.
If you’re looking for Treasury Bonds, visit TreasuryDirect.com and open an account.
What Are Mutual Funds?
With all security options available, it may be hard to know what to choose. With enough research and experience, though, you’ll learn which ones work better for you.
What if you don’t have that much time and want to get results right now? You don’t need to know everything. When investing in mutual funds, you’re paying professionals to do it for you based on your objectives.
How do you compare yourself to these giant trading agencies? Sacrifice some control, and these firms will get you the most diversified and suitable portfolio. You don’t need to study every single stock. Join one mutual fund to get everything in one place, even mixed security types.
These firms collect client capital and invest it based on their allocation and reports. Because they want to make the most profits and outperform the market, they’re always managing the fund to optimize it. You do zero work and get all the benefits of diversification: they invest your money the same way they’d do with theirs.
People with the same interests and goals join mutual funds. These can categorize by sector, marketplace, security combination, income-objectives, and an endless list of variations. You can even invest in fund-of-funds and take diversification to the next level.
Before considering mutual funds, look at their performance history and minimum investment amount. Some sites run mini-surveys to recommend the right mutual fund for you based on income level, financial goals, and preferred rates.
Since you’re essentially outsourcing the investing, firms charge you for the service. You pay an annual 0.1-2% of your portfolio to cover operational costs, advertising, and management of the firm. Actively managed funds will have higher rates.
The fund load costs around 1-5% of the value whenever you buy/sell the mutual fund (which is a similar way stock exchanges charge traders).
If you don’t know where to start, get advice from major brokers like TD Ameritrade, Vanguard, Fidelity, or Merrill Edge. Here’s a list of a dozen fund advisors compared.
How to do it?
Find the right mutual fund and contact the management firm. You can go to the mentioned brokers to ask questions and find out what funds are the best fit.
When you contact the company, they will ask for personal information, your financial goals, and the amount to invest. If you plan to sell the fund later, you’ll need to contact them as well.
What are exchange-traded funds (ETFs)?
Exchange-traded funds combine the diversification of mutual funds with the flexibility of stocks. These trade on the stock market like every other company, managing all the fund securities from a single transaction. Investors get their profits from value increases and dividends.
- Low cost: Because ETFs are passively-managed securities, service fees are lower. The minimum investment required is also lower than for mutual funds.
- Flexible taxation: You only pay for the distributed income (dividends, in this case). Unlike inflation-linked bonds and mutual funds, you don’t owe taxes until you get paid. If you invest long-term on ETFs, you may spend decades without paying anything.
- Cost-Effectiveness: Building an index portfolio from zero takes research time. Buying each security inevitably charges transaction costs. Remember the 1-5% fee with mutual funds? ETFs include all different stocks and investments in a single purchase.
- Liquidity: You can trade ETFs as much as necessary during market hours. Despite the diversification, ETFs are liquid enough to distribute dividends quarterly and update prices throughout the day.
Although they resemble mutual funds by definition, they differ in three aspects:
- Risk-reward: ETFs seek to replicate— not outperform— the market. Passive management can still be profitable long term while minimizing risk.
- Dividend yield: ETFs distribute quarterly while mutual funds do it semi-annually at most.
- Price control: Mutual funds trade at the same price and don’t update until the end of the trading day. ETFs update prices every second, like stocks.
How to do it?
What are Retirement Plans?
Retirement plans are accounts with tax benefits meant to save money long-term. These allow you to choose when to pay taxes so that you can build wealth faster, especially get rid of debt.
Before you get too excited, understand most of these accounts have yearly contribution limits (you can’t invest past a certain amount). If you want to claim retirement funds before the minimum age (usually between 55 and 59.5), you may pay taxes again plus a 10% penalty.
You won’t get rich investing with retirement plans, but the saving opportunities are worth the investment. Employer matches, for example, give you free money when contributing to your retirement fund.
Many variations apply to each type of citizen. For the sake of simplicity, we’ll cover 401ks, IRAs, and pensions.
When comparing IRAs with 401k, you need to consider:
- How are you funding retirement? Anybody can create an IRA fund, but only employees can contribute to 401ks (solo 401ks if you’re self-employed).
- How do you want to grow your account? IRAs have higher wealth potential and upfront costs. 401ks take less time to fund and receive help from employer matches.
- When do you want to pay taxes? Traditionally, you would use the pre-taxed income to fund your account, then pay when retiring. Roth plans allow paying taxes today and enjoy tax-free (compounded) money later.
Every year, you can contribute up to $19,000 (a bit extra if you’re over 55) without paying taxes. Out of your annual income, the IRS deducts your 401K investment.
Employers can contribute to your retirement as well by matching 50-100% of your investment up to some salary amount. Let it be a 100% match up to 5% of your salary. If you contribute 5% of that income to retirement ($5000, for example), the employer puts an additional $5K.
Although the IRS can tax employer contributions, these don’t include in your yearly limit (you can go over $19K).
The government tells you when to get out the money, and if you don’t, it costs more money! You can’t use the funds until you’re 59.5 without a penalty, and you must withdraw all the amount before you turn 72. By 70 years old, you should have taken out 50% of your savings, or they’re lost.
If you expect to make more money later, you may want to avoid paying taxes later. Why not pay them today, while you’re in a lower income bracket? Unless you make less money by retirement (questionable), Roth 401Ks become the most efficient retirement plans.
You only fund your account with taxed dollars with the same features of traditional 401Ks (employer matches available, $19K/year limit).
Having less money to invest today can slow down your account growth. But because we don’t know how taxes will change (and they will likely never get lower), paying in advance can save you a fortune.
Traditional IRAs (Individual Retirement Accounts):
Unlike employer-sponsored accounts, anybody can create an IRA fund with any investment types. Anything you invest here is tax-deferred. Unlike any other plan, there’s no limit on how much you can contribute. The IRS collects taxes when you receive your savings, which you have to claim by at 72.
Although unlimited funding sounds attractive, do you really want to delay taxes?
With this plan, you contribute with tax dollars up to $19K per year. Although it reduces your ability to invest, everything you earn from compound interest is tax-free money. Employer matches may still require taxes.
Roth plans allow you to make more money without having to pay more taxes for it (you pay them upfront). Because you paid in advance, you neither need to worry whether the government chooses to increase taxes.
You lose in case that taxes lower, but that’s unlikely to happen.
You can contribute up to $6000 per year to a Roth IRA and pay zero taxes when you retire. Taxing your funding dollars may delay your retirement plan, but it won’t be a problem with a high-income job. You’ll probably have maxed out those $6K before the end of the year.
Since it’s the most beneficial long-term plan, consider Roth before doing traditional IRAs.
If your savings plan isn’t enough to secure your lifestyle, pension plans can add the extra cash you need. Depending on your salary and years worked, your company may offer to keep a reduced salary for the rest of your life.
It may be less than 50% of your salary, but as long as it’s passive income, it’s nice to have. Instead of a lifetime guarantee, you can ask for a larger paycheck for a number of years (or a lump sum).
People only have a few decades left to enjoy retirement money, some having more time than others. You may want to agree on those benefits with your employer. For example, how can your family benefit from your program if you pass away sooner than expected?
Since your time is already at risk, it doesn’t make much sense to settle with “lifetime income,” no matter how comfortable that sounds.
Employers also expect you to claim this benefit after turning 60. You can redeem it earlier (55 years old), but it may not be as much money as you would receive being older. Claiming before 55 will likely involve some penalties.
But before you enjoy your money, you have to pay taxes. Unless you live in a state that exempts pension taxes, you’ll pay the IRS as if it were just another source of income.
It’s not all bad news. Even if your state taxes pensions, at least 25% of your income is tax-exempt. Your basic allowance income also deducts from quarterly reports, which is around $20K.
How to do it?
What are Cryptocurrencies?
Cryptocurrencies are digital payment methods to acquire goods and services, similar to how you do with dollars. Although these coins aren’t official yet, you can buy anywhere with virtual accounts, which convert cryptocurrency to fiat automatically.
Some companies issue credit cards for buying with crypto, and you can transfer a dollar amount to your bank account. What makes it so popular is the blockchain security technology and price volatility.
Blockchain helps to secure transactions using anonymous network computers. Examples:
- Proof of work: Each transaction identifies with a “hash,” which creates a complex algorithm we need to solve. The computer that sends the closest answer to the solution the fastest receives a “mining reward.” After a few confirmations, the fund’s transfer.
- Proof of stake: This consensus algorithm assigns transaction blocks to users based on the number of coins they held and for how long. This system reduces centralization by adding randomness or resetting coin-age after winning a block.
If you’re good at technical analysis, cryptocurrencies can be lucrative short-term because of volatility. People also expect some of them to 100x after a few decades. But with almost 7000 coins and dozens coming out each day, one never knows who’ll be the next winner.
Companies create these coins as an exclusive payment method to buy services from them. Not only are you profiting from the business, but also cryptocurrency.
Crypto investors often have conflicting beliefs. Because trends change so fast (over 20% price changes per day), people feel confused. Coin prices may spike this month and then have no activity for almost a year. It could mean that they are pumped and dumped.
How to do it?
- Open an account in any crypto exchange: Bitmex, Coinbase, Binance, Kraken, Gemini.
- Create a crypto wallet based on your security preference: hot wallets, cold storage, hard-drive, paper wallets.
- Send your money to your wallet or exchange: local peers, Bitcoin ATMs, credit card payments, wire transfers.
- Convert fiat to cryptocurrency or buy Bitcoin directly. Look at the available coins and follow a trading strategy. You can make market/ limit/ stop-loss orders.
- If you want to get back your money, enter your bank address, and confirm the withdrawal.
What are Commodities?
Does it matter who you choose to buy gold? You may get different rates, but the “product” received will still be the same. Commodities constitute the closest goods to nature with minimal human interaction. It often means trading primary market products:
- Precious/industrial metals: silver, gold, platinum, copper, aluminum
- Agricultural products: soybeans, barley, corn, wheat
- Soft commodities: coffee, cocoa, sugar, cotton
- Livestock: lean hogs, pork bellies, live cattle
- Energy resources: solar, wind, natural gas, crude oil, nuclear, coal, hydropower
Why would you want to invest in commodities?
- Real value: Despite market fluctuations, these goods always have a base value they can’t go below, just as they have a strong demand. People have always looked for ways to increase production as the population increases.
- Causality: By understanding the data and companies, one can learn to predict value changes. You won’t know the exact price, but if you see more sellers coming in, you expect prices to go down. If you hear of a disaster on the news, expect it to go up.
For the same reason, others consider commodities risky due to the many factors involved. Right now, something unexpected may affect your assets, changing prices abruptly.
Aside from those exceptions, commodities tend to follow cyclical patterns, especially agriculture. As a general overview, commodity prices have dropped this decade.
That doesn’t mean you must lose money. You can secure your investment by trading options, which is the last type we’re about to introduce.
How to do it?
The fastest way to do it is by buying stocks or ETFs. You find a company that produces those commodities or join a fund that manages them. Because prices can be volatile, you may prefer mutual funds over ETFs because of active management.
The optimal way is trading directly with producers. You search for their offers online and buy at convenient times. When you no longer want the commodity, they could buy back (expect a ~2% price markup). Due to the lack of liquidity, direct trading only proves useful when holding large amounts long-term.
- Go to any online commodity exchange or stockbroker
- Buy an ETF or mutual fund that includes commodities
What are Options and Futures Contracts?
Not all exchanges support options trading, but those that do give you a great opportunity to minimize risk.
Let’s say you choose to invest heavily after studying the market and your strategy. Do you lose all your money if you’re wrong? If you bought options as well, you’d at least break even.
Options traders pay and agree to trade an asset for a set price in the future. When prices change, you still reserve the right to trade it for the price it was when you created the contract.
Has a stock fallen from $100 to $80? If you created a put option at $100, you could now buy it for $80 and sell it for $100.
Has it doubled its price? Create a call option before that happens, so when it’s worth $200, you can buy it for $100.
You buy/long with Call options while a Put Option does the opposite. The price of these contracts depends on:
- How volatile the current market is
- What amount applies to the contract (otherwise you’d be printing money)
- How long will it be active (from 5 minutes to a year)
If you want to profit, you wait for the asset to change its price until it covers the initial expense:
You buy an Apple (AAPL) share for $200 and set a put option at that price, which might cost you $10. If the price falls, you can still sell for $200, but it needs to be under $190 to break even.
You create a call option for Procter & Gamble (PG) at $100, costing $5. It needs to rise above $105 for you to break even when buying.
What if that doesn’t happen? You don’t execute the contract. Let it expire or cancel it, and you’ll have only lost the upfront premium.
Future contracts, however, require you to complete the trade with an agreed-upon price at the set time.
Mind that investors use options and futures mostly to hedge other investments like stocks, commodities, or crypto.
With cryptocurrency, at least there is a “greater fool” willing to buy for your price. In futures contracts, they must accept it no matter what.
How to do it?
Excluding the countless variations, most investors use futures for stocks, crypto, commodities, indexes, even forex. You can go to any of their platforms to create them.
For options, you select your investment, choose Call/Put, agree on the deadline, set the amount, and pay the premium. Futures contracts work the same way, except that it trades automatically on agreed conditions (unless your trading position expires).
What Have We Learned?
Hopefully, you now know what each investment is and how to get started. Whether you should start or not is more complicated:
- What risk-reward scale do you prefer?
- Would you rather manage your fund yourself or let an expert do it, sacrificing control?
- How quickly do you want to make a return?
- Is your financial goal to retire or keep reinvesting most of it, potentially increasing your income?
Although diversification makes securities safer, you can’t optimize investing unless you focus on one at a time. Most investing decisions are irreversible. Think twice before buying and trade with what you can afford to lose.
Also, we have to mention real estate. We haven’t included it on the list because it tends to be illiquid, not as passive as managing money with ETFs, stocks, or options.
When the goal of the investment is increasing your net worth, you should also include other unconventional means. You can invest in yourself to get skills, education, influence, and earning ability.
Did you know most people have no idea what these terms mean? By reading this article, you’ve invested in financial intelligence and have more control over your future.